1. Field
This application relates to financial data processing, specifically to a method and apparatus for evaluating how various provisions included in the venture capital term sheet and definitive investment agreements will impact current and future returns to the enterprise shareholders including venture capital investors and the enterprise founders.
2. Prior Art
Venture Capital companies provide money to young, rapidly growing companies with promising new products or services in exchange for ownership in the company. Major market sectors for VC investments include software; life sciences, telecommunications, clean technologies, and media and entertainment. The US Venture Capital industry includes about 900 VC companies with over $250 billion of investments under management. According to the MoneyTree Report by PricewaterhouseCoopers, in 2008 venture capitalists invested $28.3 billion in 3,008 deals. The UK venture capital market accounts for 40% of the whole European VC market and is second in size to the United States. British Venture Capital Association, BVCA, has around 165 full member firms, which represent the vast majority of UK-based private equity and venture capital firms.
The venture capital investment process is now a well-established method of raising funds for early stage companies. Institutional venture capital comes from professionally managed funds that typically have $25 million to $1 billion to invest in emerging growth companies. Since investing in early stage companies entails significant risk, the venture capital is relatively expensive, i.e. in exchange for funds the venture capital investors demand significant equity in the business. The earlier the investment stage, the more equity is required to convince a venture capital to invest. Funds typically available for investment in a single company range from $500,000 to $10 million. The average venture capital investment is about $8 million.
The term sheet is a preliminary agreement used to anchor the key contractual provisions for a Venture Capital investment. When a VC company is interested in investing in an enterprise it typically expresses its intentions by offering a term sheet to the target enterprise The provisions of the term sheet largely cover the value of the enterprise and how much ownership the founders and other shareholders give up in order to get the VC investment. The enterprise evaluates the provisions of the term sheet and either agrees to them, rejects them or proceeds to negotiating changes to some of the provisions. When all parties agree to the provisions of the term sheet, the agreement is signed. As the next step the VC performs due diligence, followed by negotiating the definitive investment agreement, provisions of which are largely anchored by the provisions of the term sheet. Lawyers use the term sheet for drafting the investment documents.
To reach a beneficial agreement the party to the term sheet must fully understand the term sheet provisions and appreciate their financial implications. However, the term sheet provisions are very complex. Since they are written in a legal language many provisions are difficult to understand by a layman. In addition, some provisions imply the use of complex formulas which describe how such terms as liquidation preference or anti-dilution mechanism will impact future payoffs to the investors and other company shareholders, including the company founders. The matter becomes even more complicated if one tries to estimate the impact of the combination of over 20 provisions which comprise a typical term sheet. Finally, the task becomes daunting when given the specific set of term sheet provisions and the estimates of future enterprise valuations one tries to estimate probabilities of future payoffs to shareholders or evaluate the current market value of the shareholders' shares in the enterprise. Thus, to fully understand the term sheet provisions and their financial implications, the person must possess both legal and financial expertise.
While entrepreneurs, such as company founders, are full of admirable qualities, they often do not have the required legal and financial acumen to appreciate the implications of complex provisions of the term sheet. As a result they are at a disadvantage while negotiating the term sheet agreement and other investment documents based on the term sheet. In addition to lacking skills, they also lack experience in evaluating the term sheet provisions. Even a successful serial entrepreneur typically makes a term sheet-based deal no more than once every 2-5 years, while a VC is likely to make similar deals over 10 times a year, and a VC attorney 20-50 times a year.
VC attorneys representing entrepreneurs are very capable of discerning the legal language of the term sheet documents. However, they are often not sufficiently equipped to provide quantitative financial analysis of the impact of the term sheet's provisions on the investors' returns. Thus, to level the playing field and reduce the asymmetry in the ability to evaluate the provisions of the term sheet, there is a need for easy to use system which will enable all parties evaluate how various provisions included in the venture capital term sheet agreement will impact current and future returns to the enterprise shareholders including venture capital investors and the enterprise founders.
While the VC investors are typically in the best position to perform quantitative evaluation of the provisions implications they would definitely benefit from easy-to-use tools which will facilitate fast and comprehensive analysis which would allow VCs make better deals through quantitative fine-tuning of term sheet provisions. With ever changing business conditions, the prospects of VC portfolio companies are also changing. VC need portfolio management tools which taking into considerations changing market-wide and company specific forecasts determine the current market value of VC's investments governed by existing definitive investment agreements.
Previously, the parties to the term sheet agreement were provided by a sample term sheet and a written description of the provisions of the agreement. For example, a sample term sheet was produced by a coalition of attorneys who specialize in venture capital financings, working under the auspices of the National Venture Capital Association (NVCA). It is available on the NVCA web site at www.nvca.org. The general meaning of the provisions of the term sheet is explained in “A Guide to Venture Capital Term Sheets” published by British Venture Capital Association, as well as, in documents published on the NVCA web site. In addition, there are available books which explain the meaning of each term of the Venture Capital term sheet, e.g. “Term Sheets & Valuations—A Line by Line Look at the Intricacies of Venture Capital Term Sheets & Valuations “(Bigwig Briefs) by Alex Wilmerding, and “Deal Terms—The Finer Points of Venture Capital Deal Structures, Valuations, Term Sheets, Stock Options and Getting VC Deals Done” (Inside the Minds) by Alex Wilmerding. These materials also explain how a change of an individual provision, all other things being equal, will impact the future payoff to the parties of the agreement. Specifically, they explain, how to calculate a payoff to each shareholder/investor, based on specific predicted value of the enterprise at the time of the company liquidation.
Previously, there were available printed materials which explain how to use Black-Sholes call option valuation equations to value the investors share in the enterprise, based on individual provision of the VC term sheet. The option valuation methodology is used to estimate the present market value of the investor's holding.
However, the published materials don't explain how to simultaneously take into consideration comprehensive set of term sheet provisions and determine how the firm's liquidation value will be distributed to shareholders/investors under these provisions. Moreover, they don't explain how to take into consideration multiple term sheet provisions and, based on the estimated distribution of the enterprise valuation at the time of exit, estimate the statistical distribution (probabilities) of the payoffs to each party of the agreement. Also, the published materials don't explain how to take into consideration comprehensive set of term sheet provisions and, based on the estimated probability distribution of the enterprise valuation at the time of exit, estimate the current market value of each shareholder's/investor's share in the enterprise.
The published material does not describe the methods of implementing the VC term sheet evaluation apparatus, which provides easy to use comprehensive evaluation of how various provisions included in the venture capital term sheet agreement will impact current and future returns to the enterprise shareholders including venture capital investors and the enterprise founders.
In summary, previously the parties to the term sheet agreement lacked comprehensive, easy-to-use methods and apparatus which would enable them to evaluate the financial implications of the provisions of the term sheet. This situation put at a disadvantage most entrepreneurs who lack the experience and training of the venture capital investors and attorneys. It also made VC firms investment decisions less efficient.